Prepayment outlook key to MBS valuations

LAS VEGAS - If potential mortgage-backed securities investors at last week's American Securitization Forum's ASF 2006 conference remember one word, it should be "pre-payments," according to Nomura Securities International director and head of structured finance research Mark Adelson.

Attendees at Adelson's introductory MBS panel, MBS Market: Concepts and Topics, absorbed much of the sector's basics, from the ins and outs of the government sponsored enterprises to the cash flow of a mortgage pass-through.

At a time when consumers have scrambled to refinance their mortgages during years of historically low interest rates - and mortgage companies have cropped up to offer the service - factoring in the implications of prepayments plays a larger role in making an MBS investment decision, he said.

He said prepayment risk is the key source of cash flow uncertainty in MBS. Prepayment risk is higher with mortgages because consumers are more prone to refinance a larger item than small items with shorter maturities. Credit cards hold the smallest refinancing risk compared with other assets, according to Wachovia Securities. The assets at highest risk for prepayments include MBS interest-only structures, prepay levered collateralized mortgage obligations, jumbo MBS and MBS.

It is not unusual to see MBS pools with a 30% to 40% constant prepayment rate, he said. Most U.S. homeowners took advantage of low interest rates and new mortgage products to refinance their mortgages into lower coupon, and often hybrid, mortgage products in recent years. Lenders offered incentives such as teaser rates and the option of a cash-out refinancing.

Borrowing rate outlook not clear

During periods of interest rate volatility, MBS values typically fall because of the possibility of high prepayments, Adelson said. He added that while refinancings do not impair credit quality, they do reduce excess spread and subsequently credit enhancement. The activity will ultimately reduce the duration of asset cash flows relative to liabilities "until at some point a portfolio manager may have to finance the gap underwater," Adelson said.

In trying to determine a fair value for various MBS pools, he said there are several options - some art, some science. A potential investor could simply speculate about the direction of the economy and interest rates, combined with historic borrower delinquency and refinancing trends, and call it a day. However, the vast majority use an array of modeling software.

There is a wide divergence of opinion regarding future prepayment trends.

"What you will see is there is a complete disagreement among all the different Street firms as to how fast or slow borrowers will prepay," Adelson said.

One solution to help slice up what could be sharp prepayment curves is the use of such structures as collateralized mortgage obligations and REMICs, he said. The CMO essentially "cuts up" mortgage payment cash flows into planned amortization classes. The PAC in a CMO segregates various levels of risk, with the higher risk bonds paying a higher yield while the lower risk, which are more likely to receive constant payments, are matched with a lower yield. The PACs may be cushioned with the so-called "companion bonds," which receive distributions when prepayment speeds are in range and are the first to erode by rapid prepayments. The companion bonds, Adelson said, are not always so friendly to the buyer.